Unlike your commute or those conference calls, income taxes don’t go away once you hit retirement. In fact, income taxes can be your single largest expense in your retirement years, which means it’s important to have a sense of what’s coming, so you can plan for it.
However, many retirees don’t have a good grasp on what exactly qualifies as taxable income during retirement and how large a tax bill they can expect. In addition, many find they’re not actually in a lower tax bracket than when they were working. This can feel counterintuitive, but in retirement, you may not have the tax deductions you once had, including those for claiming dependents, deferring 401(k) contributions, and mortgage interest deductions.
Every retiree’s situation is different, but it’s a good idea to know where you might pay taxes and where you likely won’t have to. Get started with this overview, and be sure to consult your wealth advisor and tax professional about your individual tax situation.
What you’ll have to pay taxes on
Social security benefits
You may be surprised to find out you have to pay taxes on something that was withheld from your paycheck by the federal government, but yes, social security benefits are taxed. Just how much of your social security benefits qualify as taxable will depend on your marital status and overall retirement income, but the range is between 50% and 85%.
Naturally, the more income you have, the higher your taxes on social security. What’s more, your social security benefits could have the effect of pushing you into a higher tax bracket. To find out how much of your benefits will be taxable, use the IRS calculator.
Withdrawals from tax-deferred investments
You will be required to pay taxes on withdrawals from tax-deferred investments in the withdrawal year. These investments include traditional IRAs, 401(k)s, 403(b)s and other retirement accounts. Remember, you must take RMDs (required minimum distributions) starting at age 72, and those withdrawals can also push you into a higher tax bracket.
Even though your employer withholds taxes when it makes pension payments to you, you’ll still be required to pay additional federal income tax on pension annuities and pension payments. These taxes will be at your regular rate.
Taking a lump-sum payment directly from your pension? Then you’ll need to pay the total tax due when you file your tax return for the year in which you received those funds.
Dividends and interest
You’ll pay taxes on dividends and interest from stocks or bond funds (not including municipal bond funds), and also pay taxes on capital gains when you sell. These will be taxed at the long-term capital gains rate of between 0 and 20%.
You’ll pay taxes at least a portion of the total income from annuities. If you purchase an annuity in retirement, the portion of the payment that represents the principal is tax-free, but the rest is taxable. However, if you purchased the annuity with pre-tax dollars, 100% of your payment would be taxed as ordinary income at your ordinary income tax rate.
Where you won’t pay taxes
There are a few areas where you can expect not to have to pay taxes. These include:
- Roth IRAs, which are funded with after-tax dollars, meaning any withdrawals in retirement are tax free. (This is only if you have held the account for five years or more.)
- Life insurance proceeds aren’t taxable (if your spouse dies and you receive a life insurance payout).
- Giving cash gifts to beneficiaries is tax free, so long as you comply with IRS rules and lifetime exclusion provisions.
- Transferring wealth to family members or friends (up to a certain amount) can also be a way to avoid incurring estate taxes.
Of course, there are wealth management and tax-efficient investing strategies that can help you minimize your tax burden in retirement. Ironwood Wealth Management can help you mitigate that impact, so you can make the most of your retirement years. Contact us to learn more.
**All information and assumptions are based on information as of June 2021. Tax rates and tax policy are subject to change.